Officially the FOMC replaced its nonborrowed reserves operating procedure with a borrowed reserves operating procedure when it deemphasized M1 in its monetary policy deliberations in October 1982. However, Thornton (2006) shows that unofficially the operating objective was the overnight federal funds rate. Initially, the FOMC “targeted” the funds rate in much the same way as it did during the pre-October 1979 period. For policy, the FOMC continued to
focus on monetary aggregates (primarily M2 and, to a lesser extent, M3). The funds rate was used as an operating objective, similar to how it was used in the mid- to late 1970s. In discussing the FOMC’s practice from “1983 to the late 1980s,” Meulendyke (1998) notes, the Committee adjusted its operating objective up or down, “whenever money seemed to be deviating significantly from the desired growth path.”23
The FOMC shifted from using the funds rate as an operating target to using it as a policy target, as policymakers became increasingly skeptical of the usefulness of monetary aggregates for policy purposes. For example, at the February 10, 1988, meeting, Greenspan noted that “there has been more data mining with the monetary aggregates in the last two years than I’ve seen with any other set of data in my whole life. And whenever you get to that, you know that there’s nothing there. We can expand away or we can contract, but I don’t think it matters.”24
Thornton (2006) documents that discussions of the extent to which the Committee was targeting the funds rate and the desirability of doing so occurred frequently in 1988 and Committee members became increasingly open about the extent to which they were focusing on the funds rate in their policy deliberations.
The transcripts of FOMC meetings make it clear that the funds rate was being used as a policy target by early 1988. For example, on May 9, 1988, the funds rate objective was increased from 6.75 percent to 7.0 immediately
following a May 6, 1988, conference call. There is no transcript of this conference
23 Meulendyke (1998), p. 53.
24 FOMC Transcript, February 10, 1988, p. 44.
call; however, the discussion at the May 17, 1988, FOMC meeting indicates that the increase was in response to concerns about inflation.25
at this particular stage in the cycle, if we are running into the type of acceleration and inflationary process which is at the forefront of our concerns…I don’t think there is any question that the next move that we have to make is on the upside. And the only question, basically, is whether we do it now or we do it before the next FOMC meeting on the basis of certain contingencies.
Chairman Greenspan opened the policy discussion at the May 17, 1988, meeting by noting that
26
Most FOMC participants continued to use the code of incremental changes in the
borrowing assumption; however, others were more candid. For example, concerned about small incremental moves in the funds rate target in the current environment, President Melzer noted
at some point we’re going to have to step out in front of this situation if everything we’ve heard today is correct. And that’s going to take
something more on the order of alternative C. The timing issue has been talked about. I would guess…that if you [Chairman Greenspan] had the benefit of all this discussion you might have moved it a full 50 basis points [referring the 25-basis-point increase in the funds rate target on May 9], and we wouldn’t get into two increments of 25 basis points.27
Greenspan summarized the Committee’s views by stating
there seems to be a consensus for alternative B and asymmetrical language, with a fairly strong willingness—desire, if I can put it that way—to give instructions to the Chairman and the Desk to move before the next period. I would interpret that to mean that, unless we see events which clearly are contrary to the general consensus of the outlook as one hears it today, it’s almost an automatic increase. There is a strong, and I
25 It is interesting to note that Poole, Rasche, and Thornton (2002), who examined the Credit Market column of the Wall Street Journal two days before and after changes in the Fed’s funds rate objective to determine whether the market was aware that the Fed was targeting the funds rate or that the funds rate target had changed, found that “the first time in the 1980s that market participants knew that policy action occurred was May 9, 1988, when the Desk injected fewer reserves than analysts expected. This action sparked speculation that the Fed was increasing its fight against inflation, and market analysts concluded that the action would cause the funds rate to trade at 7 percent or slightly higher.” Poole, Rasche, and Thornton (2002), p. 73.
26 FOMC Transcript, May 17, 1988, p. 1. There is no available transcript for the first part of this meeting.
27 FOMC Transcript, May 17, 1988, p. 10.
think convincing, case that is being made that we should not, under any conditions, allow ourselves to get behind the power curve on this question.28
Consistent with this statement, Greenspan increased the funds rate target from 7.0 to 7.25 percent on May 25. Fears of accelerating inflation prompted the FOMC to increase the funds rate target another 250 basis points by February 24, 1989.
This shift toward using the funds rate as a policy target also corresponds well with the Asso et al. (2010) documentation of the increased interest among Fed policymakers in the Taylor rule in the mid 1990s and the trend toward using a short-term interest rate to implement policy decisions in other central banks.
The change in the FOMC’s use of the funds rate is further evidenced by the behavior of the funds rate target during the first half of 1989. Short-term market rates, such as the 3-month T-bill rate, peaked in late March 1989 and began to fall. Nevertheless, concerned about inflation, the FOMC made a small, 6.25-basis-point increase in the funds rate target on May 17, 1989. More
importantly, the FOMC did not reduce its target for the funds rate despite a sharp drop in other rates. For example, between March 27 and June 6, 1989 (the date of the FOMC’s first 25-basis-point cut in the funds rate target), the 3-month T-bill rate declined 96 basis points and the 10-year Treasury yield declined 112 basis points.29
At the conference call on June 5, 1989, Greenspan announced that he was requesting the Desk to adjust the borrowing objective to bring the funds rate down 25 basis points. In response to one Committee member’s concern about the
28 FOMC Transcript, May 17, 1988, p. 10.
29 For a more detailed analysis of this period see Thornton (2004).
“urgency” of the move given uncertainty about inflation and the strength of the economy, Greenspan responded that his “major concerns are (a) the money supply data and (b) evidence that is emerging that the commodity price inflation is
beginning to subdue.”30
total reserves decreased by $0.89 billion during the period from February to May. This is the largest three-month decline in total reserves in the entire period from January 1959 to March 1995.
This is remarkable because consecutive monthly decreases in reserves are uncommon owing to the need to increase the monetary base to meet the growing demand for currency. The effect of these actions on banks was direct and substantial. M1—which had been growing at about a 3.5% rate during the previous year—declined by $11 billion between February and June 1989.
Consistent with Greenspan’s concern, Thornton (2004) notes that
31
The behavior of reserves and M1 is consistent with the idea that the FOMC was using the funds rate as a policy target. To maintain the target in the face of declining interest rates, the Fed had to drain a significant amount of reserves, which produced a correspondingly large decline in M1. Concerned about the effects of such an atypical decline in M1 on the real economy, Greenspan opted to adjust the funds rate target, but only when the effect of the Fed’s restrictive
actions on the monetary aggregates became sufficiently large.
In contrast, when questioned at the February 10, 1988, FOMC meeting about why he reduced the funds rate target by 25 basis points on January 28, 1988, Greenspan noted that he did so in part because “the markets were coming down on their own at that particular time—clearly trying to seek a somewhat
30 Transcript FOMC Conference Call (1989), p. 3.
31 Thornton (2004), p. 494.
lower market rate level.”32
The marked change in the Committee’s emphasis on the funds rate is evidenced in the monthly average difference in the daily funds rate from the funds rate target present in Figure 6. The vertical line denotes May 1988. Beginning about May 1988, the FOMC appears to increase its control over the funds rate.
The average absolute difference between the funds rate and the funds rate objective during the 65 months between January 1983 and May 1988 is 16 basis points—about the same as during the 1970s. Moreover, the funds rate objective was adjusted frequently—36 times, an average of once every 1.8 months. In contrast, the average absolute difference during the 68 months from June 1988 through January 1994 was just 7 basis points. The target was also adjusted less frequently—30 times, an average of once every 2.25 months. After the FOMC began the practice of announcing policy actions in February 1994, the absolute difference became even smaller and target changes less frequent. The absolute average difference from February 1994 through March 2007 was just 2.6 basis points, and there were 49 target changes, an average of one every 3.25 months.
In this case, the change in the target was essentially an endogenous response to a change in interest rates.